“For Want of a Nail”: ERM for the Regulators

During the Revolutionary Era in this country, Benjamin Franklin printed an old English rhyme in his Poor Richard’s Almanack that touted the benefits of preparedness and preparation:

For want of a nail the shoe was lost.

For want of a shoe the horse was lost.

For want of a horse the rider was lost.

For want of a rider the battle was lost.

For want of a battle the kingdom was lost.

And all for the want of a horseshoe nail.

A little over two decades ago, in the wake of what was then the worst stock market meltdown since the Great Depression—in October 1987—President Reagan issued an executive order creating the President’s Working Group on Financial Markets. The Working Group technically consists of the Secretary of the Treasury (who is its chairman) and the chairmen of the board of governors of the Federal Reserve System, the Securities and Exchange Commission, and the Commodity Futures Trading Commission (or their designees). During the corporate crisis of 2001, the Working Group also regularly included the president’s chief economic adviser.

Initially intended to provide future “nails” by dealing with “the major issues” arising from the 1987 market crash, the President’s Working Group has remained in effect and has provided vital advice on how to deal with various market crises that have arisen over the twenty years since it was founded. Unfortunately, this particular executive order—unlike most federal government pronouncements—is too terse to provide much guidance or any real mandate. What seemed unthinkable back in 1987, of course, has now become commonplace.

Since the founding of the President’s Working Group, there have been at least four additional meltdowns that have forced the U.S. government to intervene in financial markets. Utilizing the clear perspective of hindsight, each of these major disturbances, and numerous additional “moderate” crises, was both foreseeable and preventable. As annoying as hindsight might be (especially to those who invariably are criticized when a crisis occurs), insult has been added to injury, since certain individuals and firms took advantage of these crises to prosper at the expense of our national economy, and, today, global financial market stability.

It’s ironic, but tragic, that the fundamental core of all U.S. financial regulation—the requirement that firms identify, assess, plan for, and ameliorate market risks—has long been missing from the way this country’s regulators oversee our financial and capital markets. With the release of Treasury’s Blueprint for a Modernized Financial Regulatory Structure, we’re only now just embarking on a long overdue examination of the way this country regulates its financial and capital markets. But, it does not take a blueprint to identify the one obviously missing ingredient in our regulatory arsenal—the application of risk assessment and amelioration, in the form of enterprise risk management. Government long ago should have learned the folly of a mantra that encourages the private sector: “Do as I say, not as I do.” And yet, for all the requirements of transparency and risk assessment imposed on those who provide financial services, the government has been woefully inept at requiring at least as much of itself.

It’s long been noted that there’s no foolproof way to make money on Wall Street, but there are plenty of time-tested, proven, and foolproof ways to lose large amounts of money with absolute certainty. The 1987 October equity market sell-off was triggered by “portfolio insurance.” Brokers established programs for financial institutions that allowed them to control their market exposures by constructing theoretical “put” positions and delta trading them. This is fine, but that technique requires financial institutions embracing it to accelerate selling as the market falls. If enough large institutions engage in selling at the same time, markets panic and the result is what was produced in October 1987.

After the Federal Reserve was compelled to step in, that problem appeared solved, but financial services firms merrily invented even more creative ways to impale themselves on their own financial spears. In the resulting real-estate crisis of 1990, the Federal Reserve had to encourage (and stimulate) banks to buy long-term bonds, financing them with short-term borrowings, in order to offset losses on commercial real estate investments. Thereafter, the Long Term Capital Management crisis arose, with the Federal Reserve discovering what Wall Street had known for years—everyone was copying LTCM’s trades—leaving no one to provide buying demand when LTCM had to sell off its gargantuan portfolio and a selling panic ensued.

In 2000 and 2001, growth stocks tumbled as the technology-weighted NASDAQ index lost 50 percent of its value after loudly proclaiming a new era in investing. As financial services firms touted investments based on flimsy and fleeting wisps of ideas and promises, technology stocks cratered. As impressive as those three crises were, we’re currently dealing with the sub-prime crisis—a crisis in which continually downward-spiraling low interest rates from 2002 through 2005 encouraged speculative lending to less than credit-worthy home borrowers. As long as house prices rose, the world was sunny; but when interest rates started to rise (or adjustable mortgages started to reset) and housing prices fell, the inevitable chicken came home to roost.

In the aftermath of the sub-prime crisis, we are now confronting the “Bear Stearns” phase of that crisis—the situation where a financial services firm overextends itself beyond its wildest imaginings, reaping huge profits in the early stages, but suddenly awakening to find that no one else in the financial markets sandbox wants to play with it! Contrary to some press assertions, Bear Stearns was not too big to fail. Indeed, in looking at the buyout, it is clear that Bear Stearns did fail, at least as far as its equity holders are concerned. But what was, and remains, too big to fail is the U.S. economy, and the threat posed by Bear Stearns was not that it would fail, but that it would bring down everyone around it.

All these incidents would have had less impact on the U.S. economy than they actually wound up having, with only a modicum of foresight and planning. What makes the sub-prime crisis so devastating is that, as a result of the joint efforts of global investment banking firms and the ratings agencies, credit counterparties decided that no one really could trust the integrity of any Triple A rating. While many Triple A rated instruments were worth what they were always worth, the new market wisdom required credit counterparties to examine every credit instrument or derivative individually, to see if it was really worth a Triple A rating. This began a contraction (and eventual shutdown) of the U.S. credit markets that has extended overseas as well.

To their credit (pun intended), many hedge funds and large financial institutions prospered from the fall of the sub-prime market. Management of these institutions correctly analyzed the excessive credit extensions and positioned their institutions either to avoid them or take advantage. The inevitable decline in technology came from investors’ attempts to sell all their “old-age” stocks and participate in the dot.com economy, which was forecast to expand infinitely. Again many investors and institutions had the foresight to sell technology securities short while others were buying, and avoided (or profited from) the mess.

Historically, there have been signs that these excesses were on the horizon long before they morphed into economic catastrophes. Repeatedly being caught off-guard should have signaled to regulatory agencies that they were lacking fundamental tools regarding the identification of problems before they actually arise. And yet, from 1987 until 2008, virtually nothing changed in the way the principal U.S. regulatory bodies functioned.

Treasury’s blueprint contains provocative and thoughtful suggestions about rationalizing and streamlining the current regulatory morass. Its emphasis on “objective-based” regulatory roles is long overdue. And it contemplates that regulators should abandon their present-day rules-based, or prescriptive, approach and attempt to move toward a principles-based approach. In that approach, concern is focused on preventing and fixing problems, rather than only prosecuting the guilty after the fact. Unfortunately, the implementation of any fundamental change in our regulatory system is likely to take years to study and debate, and thereafter, at least a decade or more to implement.

An interim step would be to create a Risk Management Committee on the President’s Working Group on Financial Markets. This Risk Management Committee would be charged with making an annual, top-down, risk-based assessment of the U.S. financial system and suggesting steps that should be taken in order to prevent and ameliorate the situation. It would also be available when the inevitable crisis arises, to coordinate responses and to identify additional concerns that the crisis might exaggerate. This group would address a subject that is currently being done, if at all, on an ad-hoc, segregated basis in different agencies throughout the government. It would offer an insight into the benefits of a principles-based approach, and it could serve as its own blueprint for the further evolution of our existing regulatory system. Its main purpose, though, would be to keep small problems from turning into big ones.

Private-sector participation is essential. My years in government have taught me that government seems far more adept at examining the past than anticipating the future. When I became chairman of the SEC in 2001, for example, the agency had never—not once in its nearly seven decades—ever conducted a top-down management review of efficiency and processes. While the result of the review I commissioned recommended the creation of a risk-management group within the SEC, this recommendation has taken years to implement, and even then with a paucity of resources that makes the effort almost worse than never having undertaken it.

Government all too often tends to approach problems with legal analyses that start by worrying whether it has the authority to do creative things. That, at least, is one of the things that was so refreshing about the Federal Reserve’s decision to open its discount window to investment banking firms, something it had never done since its inception. The Fed was willing to think creatively, and that was critical in stemming the potential crisis that was unfolding. Avoiding crises usually requires thinking outside the constraints of the government’s box.

Second, government often finds it difficult to attract necessary talent, and that problem is only getting worse. Our current environment is typified by politicians playing the “blame game”; namely, when something goes wrong, rather than trying to solve problems cooperatively and constructively, politicians and government agencies generally tend to try to “profit from the crisis” by finding someone to blame. Not surprisingly, neither government nor Congress ever blames itself, but Congress blames government, and government often blames Congress (except when testifying before Congress).

Establishing a Risk Management Committee on the President’s Working Group would necessitate populating it with experienced private-sector individuals with the experience and viscera to recognize problems before they arise. JPMorgan Chase’s and Goldman Sachs’s managements knew the sub-prime market was overheating long before the first articles appeared or hearings commenced. That’s the reason that Goldman Sachs has, at least thus far, avoided serious catastrophe in its own sub-prime efforts, and that JPMorgan Chase was able to backstop Bear Stearns. Unfortunately, that type of experience seems always to be gained only by first suffering hard lessons in financial markets. And, it is altogether nonexistent in government.

Legislative representation on this committee would also be important. An informed Congress that isn’t yet confronted with the next crisis can assist government regulators in containing issues, rather than figuring out which ones to blame. In most financial up-cycles, legislators are beset by constituents extolling the virtues of the latest financial craze, from tech stocks to 125 percent loan-to-value mortgages. In the midst of these euphoric highs, it would be useful to have a group that can remind all of us of the dangers of the lows. It is instructive to recall the Roman emperors, who reputedly hired people to whisper in their ears “don’t believe it all” as they paraded in triumph through Rome.

A risk management committee should be charged with preparing an annual report that identifies major potential risks to the U.S. economy and financial markets during the coming year, and the state of preparedness that exists should those risks eventuate. Such a report would need to be succinct and done anew each year, so that it served as something more than a litany of clichés. The goal would be to identify key issues, like sub-prime or other overheated markets, that pose immediate concern to the U.S. financial markets. In addition to identifying potential problems, it would suggest steps that should be taken to avoid or to ameliorate identified risks.

The report that would eventuate should be reviewed by an independent body, in order to determine if the Risk Management Committee has performed a thoughtful analysis and followed reasonable procedures in its assessment process. Because it is unlikely legislation can emanate during our politically overcharged Presidential election year, the Risk Management Committee would not have any ability to compel formal actions to be taken. But, given my own experience with the President’s Working Group, I believe that the recommendations that emanate from such a committee would carry very persuasive weight with the constituent members of the President’s Working Group and that its most forceful and thoughtful suggestions would likely be adopted.

If implemented correctly, this Government Risk Management Committee would:

identify potential issues before they become significant problems;

enable government to avoid costly nationwide failures;

coordinate and better inform the actions of various regulators;

provide a useful interaction point between finance and the government because, as the government increasingly takes on the role of a guarantor, the government needs to understand these businesses;

encourage the adoption of a principles-based approach to problems, thus, serving as a blueprint for future reforms; and

enable government to take advantage of the considerable amount of effort that the private sector has already devoted to enterprise risk management.

What is more, this is something that can be done without legislation, or years of study and debate. Given the traumas of the past two decades, and even more specifically the tragedies of the past year, it’s time to entertain new concepts. Those who worry that a Risk Management Committee would threaten the independence of our existing regulatory structure need only look at Bear Stearns. For want of a nail, our entire economy and our financial markets were placed in jeopardy. If creating a governmental Risk Management Committee could avoid or ameliorate even one financial crisis, it would prove to be the critical “nail” that is well worth whatever costs are associated with its creation.